February 2010
Inside this issue:
Boards in the Spotlight: New
Disclosure Requirements .......... 1
SEC Chairwoman Schapiro Calls
for Fundamental 12b-1 Reform . 3
SEC Director Donohue on
Challenges Facing Independent
Directors .................................... 4
Boards in the Spotlight: New Disclosure
Requirements
On December 16, 2009, the SEC adopted amendments to the proxy rules
for both registered investment companies and operating companies, and
amendments to the registration forms for open- and closed-end investment
companies. The new provisions require investment companies to provide
new or expanded disclosure on the leadership structure of the board, the
board’s oversight of risk management efforts, and qualifications for board
membership.
SEC Receives Recommendations
on Selecting Investment Advisers,
Proxy Statement Disclosure Changes
Companies for Examination ...... 5
President Announces New
Board Leadership Structure
Enforcement Task Force ........... 7
The SEC’s amendments require disclosure of the board’s leadership
structure, including:
Court Dismisses Excessive Fee
·
whether the same person serves as both principal executive officer and
board chair;
·
whether the board chair is an “interested person” of the fund as
defined in the Investment Company Act;
·
if one person serves in both roles, or if the board chair is an interested
person, whether the registrant has a lead independent director and what
specific role the lead independent director plays in the leadership of
the board; and
·
why the registrant has determined that its leadership structure is
appropriate, given the specific characteristics or circumstances of the
registrant.
Interagency Financial Fraud
Case But Criticizes Directors..... 8
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The Adopting Release states that the amendments regarding disclosure of
the board’s leadership structure “are intended to provide investors with
more transparency about the company’s corporate governance, but are not
intended to influence a company’s decision regarding its board leadership
structure.”
Indeed, the Adopting Release, in discussing companies in general, notes
that “different leadership structures may be suitable for different
companies depending on factors such as the size of a company, the nature
of a company’s business, or internal control considerations, among other
things.”
Board Role in Risk Oversight
The amendments also require disclosure of
the extent of the board’s role in overseeing
risk management, such as how the board
administers its oversight function, and the
effect that this has on the board’s choice of
leadership structure. The Adopting Release
notes that the SEC changed its description of
this requirement from the proposing release,
which called for a discussion of the board’s
role in the company’s “risk management.”
The Commission cited comments on the
proposal urging that the board’s role is not
risk management, but “to oversee
management, which is responsible for the
day-to-day issues of risk management” and
that risk oversight is a “key competence” of
the board.
should serve as a director of the fund. This
information is required for all directors,
whether or not they are up for reelection
(although, in accordance with the general
instructions, information need not be
provided with respect to directors who will
not continue to serve after the election to
which the proxy statement relates). Although
certain disclosure requirements relate only to
the last five years, disclosure under this item
should cover more than the past five years,
including “information about the person’s
particular areas of expertise or other relevant
qualifications, if material.” Proponents other
than the registrant that put forward candidates
for director must include this information in
their proxy materials.
Prior Directorships
The Adopting Release notes that funds face a
number of risks, including “investment risk,
compliance and valuation.” The release states
that the Commission’s new disclosure
requirement should provide important
information to investors about how a fund
perceives the role of its board and the
relationship between the board and the fund’s
adviser in managing material risks facing the
fund. In discussing this requirement, the
Adopting Release states that companies have
the flexibility to describe how the board
administers its risk oversight function, such as
through the whole board, or through a
separate risk committee or the audit
committee, for example. The release notes
that companies may want to discuss how the
board interfaces with individuals who
supervise the day-to-day risk management
responsibilities.
A proxy statement must now disclose any
directorships held during the past five years
by each director or nominee for election as
director in any company with a class of
securities registered under Section 12 of the
Exchange Act or subject to the requirements
of Section 15(d) of the Exchange Act, or any
registered investment company (collectively,
“Reporting Companies”). The Adopting
Release states that this information will allow
investors to better evaluate the relevance of a
person’s past board experience, “as well as
professional or financial relationships that
might pose potential conflicts of
interest . . . .”
Qualifications and Experience of Directors
and Nominees
·
Another of the SEC’s amendments requires
disclosure of the specific experience,
qualifications, attributes, or skills that led to
the conclusion that each director or nominee
2
Februray 2010
Prior Legal and Disciplinary Actions
The amendments also require disclosure of
whether any director, nominee or executive
officer was the subject of, or a party to:
any federal or state judicial or
administrative order, judgment, decree or
finding, not subsequently reversed,
suspended or vacated, relating to alleged
violation of:
Investment Management Update
o any federal or state securities or
commodities law or regulation,
o any law or regulation respecting
financial institutions or insurance
companies, or
o any law or regulation prohibiting
mail or wire fraud or fraud in
connection with any business
entity; or
·
any sanction or order, not subsequently
reversed, suspended or vacated, of any
self-regulatory organization or equivalent
organization.
The Adopting Release notes that companies
may define diversity in various ways, with
some looking to differences of viewpoint,
professional experience, education, skill and
other individual qualities and attributes that
contribute to board heterogeneity, while
others may focus on diversity of race, gender
and national origin. The Commission noted
that, for purposes of this disclosure
requirement, “companies should be allowed
to define diversity in ways that they consider
appropriate.”
Registration Statement Disclosure
Changes
The language of this provision, which
requires disclosure where a person is “the
subject of or a party to” a proceeding
“relating to” alleged violations of the named
statutory or regulatory provisions, is
potentially very broad. Registrants
responding to the new requirements may omit
disclosure of proceedings that are not
“material to an evaluation of the ability or
integrity” of any director, nominee or
executive officer.
Registration statements must now include
disclosure similar to that described above
regarding:
·
the leadership structure of the board;
·
the extent of the board’s role in risk
oversight;
·
directorships held by fund directors
during the past five years in any
Reporting Companies; and
This new requirement to disclose a director’s
or nominee’s involvement in various legal
proceedings covers proceedings occurring in
the past ten years.
·
the specific experience, qualifications,
attributes or skills that led to the
conclusion that each board member
should serve as a director of the fund.
Role of Diversity in Considering Board
Candidates
Effective Date
Current disclosures must include a description
of the board’s process for identifying and
evaluating nominees for director. This
requirement has been amended to include
disclosure of whether and, if so, in what way,
the nominating committee or the board
considers diversity in identifying nominees.
If the committee or the board has a policy
with regard to consideration of diversity, the
registrant must describe how the policy is
implemented, as well as how the committee
or the board assesses the effectiveness of its
policy.
All amendments are generally effective
February 28, 2010.
SEC Chairwoman Schapiro
Calls for Fundamental
12b-1 Reform
SEC Chairwoman Mary Schapiro repeated
her call for reform of 12b-1 mutual fund fees
in a speech at the Consumer Federation of
America’s annual financial services
conference.
3
The speech focused on the protection of retail
consumers and the need to provide “clear,
simple, meaningful disclosure at the time they
are making an investment decision.”
Ms. Schapiro stated that the regulation of
12b-1 fees requires a “more fundamental
change than merely disclosure reforms and a
name change. We must critically rethink how
12b-1 fees are used and whether they continue
to be appropriate.” Ms. Schapiro listed
reform of 12b-1 fees as one of the
“meaningful and effective financial reforms”
being sought by the SEC.
the SEC’s Division of Investment
Management, Andrew “Buddy” Donohue,
discussed what he views as some of the
challenges facing independent directors that
are “less obvious” than recurring matters
such as approving a fund’s investment
advisory agreement, “but every bit as
important.” Mr. Donohue identified the
following areas as “highlighting the necessity
for . . . continued vigilance” on the part of
independent directors:
She noted that 12b-1 fees are “automatically
deducted from mutual funds to compensate
securities professionals for sales and services
provided to mutual fund investors.”
However, Ms. Schapiro warned that “the
problem is that our investor may have no idea
these fees are being deducted or who they are
ultimately compensating.” A key issue to be
addressed, according to Ms. Schapiro, is
whether some investors are “overpaying for
services or paying for distribution services
that they may not even know they are
supposed to be getting.”
Mr. Donohue addressed the situation where
an adviser agrees to waive a portion of its
fees above a capped expense ratio and
simultaneously sets up a program to recapture
those waived fees, typically in the next three
years, if expenses fall below the cap. He
stated that the SEC staff’s position is that “in
order for advisers to recapture waived
fees, the adviser may do so only in
accordance with the original recapture
plan,” regardless of any subsequent
increase in the expense cap. He stressed
that “independent directors should be
cautious if an adviser asks the fund to
increase the expense cap in order to allow the
recapture of fees already waived by the
adviser” and said that “it is difficult to
articulate how a board would find such a
transaction to be in the best interests of fund
investors.”
Noting the substantial growth of 12b-1 fees,
from “just a few million dollars in 1980 when
they were first permitted” to “more than $13
billion” in 2008, Ms. Schapiro observed that it
is past time to reassess the “need” and
“effectiveness” of the fees. Ms. Schapiro
stated that she has asked the staff for a
recommendation on 12b-1 fees for
Commission consideration in 2010. The issue
has been under consideration at the SEC for
several years now.
SEC Director Donohue on
Challenges Facing
Independent Directors
In a recent speech before the Independent
Directors Council Conference, the director of
4
February 2010
Expense Recapture
Management Entrenchment
Mr. Donohue cautioned directors, particularly
those that oversee closed-end funds, “to be
prudent in their responses” to takeover
attempts. Discussing several examples of
takeover defenses, including a request by
management to adopt a “poison pill,” to
invoke voting restrictions, or to pursue other
strategies that have the effect of entrenching
management, Mr. Donohue noted the
skepticism contained in the federal law
regarding “actions that would tend to
Investment Management Update
entrench management if such action is
harmful to shareholders.” He admonished
directors to ask “not just whether the
action is legal under state and federal law,
but whether it is truly in the best interests
of fund shareholders.”
problem with the “floor” approach is that
it “only limits the downside without
proportionally limiting the adviser’s
upside” and that, in order to be
permissible, “incentive adjustments must
be symmetrical.”
Fund Mergers
“Yield” and Managed Distribution Plans
Mr. Donohue observed that “this year we
have witnessed a significant increase in the
number of fund mergers” and reminded
directors to consider questions such as how a
“merger affect[s] the investment strategy of
the fund,” whether the merger “will result in
higher costs for shareholders of the acquired
fund” and what the tax consequences are. In
addition, he noted that, although “a merger
can be beneficial to shareholders for
numerous reasons,” some recent mergers
“appeared to be structured for the sole
purpose of merging away a fund with poor
performance.” Mr. Donohue gave examples
of particular merger scenarios that might draw
the SEC staff’s scrutiny, stating that “[i]f a
poorly performing fund is merged into
another fund, directors must be cognizant of
the accounting survivor analysis that
determines which fund’s performance is
carried over to the new entity.”
Mr. Donohue discussed “disclosures
associated with a fund’s yield or its managed
distribution plan,” whereby closed-end funds
“sometimes tout a high, level dividend or
managed distribution plan to investors,”
possibly leading investors to “incorrectly
believe that the dividend rate is ‘yield,’ i.e.,
earned income or gain,” when it may in fact
include a return of capital. He stated that
directors “must make sure that the fund’s
disclosures explain what the distribution
yield represents and what it does not
represent and that it is not confused with
the fund’s actual performance.” In
particular, he noted, “if a fund with a
managed distribution plan does not earn
enough income to sustain a distribution, it
must be clear that distributions to investors
may be paid from a return of capital which
has the effect of depleting the fund’s assets.”
Fulcrum Fees
Mr. Donohue addressed the topic of “fulcrum
fees,” explaining that “[i]n a nutshell, a
fulcrum fee is a performance-based fee that an
adviser charges a fund when the adviser
achieves a return above a certain benchmark.”
Conversely, he stated, a fulcrum fee may
force an adviser “to reimburse the fund when
there is a significant decline in assets coupled
with poor performance.” In those instances,
the SEC staff has “observed that some
funds … try to implement a floor total fee,
which would limit the downside to an adviser
by providing it a minimum cash payment and
prevent the adviser from ever having to
reimburse the fund.” He stated that the
SEC Receives
Recommendations on
Selecting Investment
Advisers, Companies for
Examination
The SEC’s Office of Inspector General
(OIG) has recommended changes
“designed to strengthen the [SEC’s]
process for selecting Investment Advisers
and Investment Companies for
examination.”
5
OIG’s review of, and resulting
recommendations to improve, the SEC’s
examination selection processes come in the
wake of the SEC’s failure to uncover the
illegal activities of Bernard Madoff’s
investment firm. As a result, the
recommendations propose new rules,
policies and protocols that are designed to
enhance communications, investigations
and data sharing, so as to better address
negative information uncovered about an
investment adviser or investment company.
The Office of Compliance Inspections and
Examinations (OCIE) endorsed OIG’s
recommendations, each of which follows:
·
Research existing data. “[A]s part of its
process for creating a risk rating for an
investment adviser . . . OCIE staff
[should] perform a search of Commission
databases containing information about
past examinations, investigations, and
filings related to the investment adviser.”
·
Use data from all sources. “OCIE should
change the risk rating of an investment
adviser based on pertinent information
garnered from all Divisions and Offices of
the Commission, including information
from OCIE examinations and
Enforcement investigations, regardless of
whether the information was learned
during an examination conducted to look
specifically at a firm’s investment
advisory business.”
·
·
6
Share data with Enforcement. OCIE and
the Division of Enforcement should create
“a joint protocol providing for the sharing
of all pertinent information . . . identified
during the course of an investigation or
examination,” including violations of
securities laws or an adviser’s disciplinary
history.
Better evaluate negative information.
“OCIE should establish a procedure to
thoroughly evaluate negative information
February 2010
that it receives about an investment
adviser and use this information to
determine when it is appropriate to
conduct a cause examination of an
investment adviser.”
·
Investigate discrepancies from past
filings. When OCIE learns of negative
information about an investment adviser,
“OCIE should examine the investment
adviser’s Form ADV filings and
document and investigate discrepancies
existing between the adviser’s Form ADV
and [previously learned] information”
about the registrant.
·
Develop review procedures after
learning bad information. “OCIE should
establish a procedure to thoroughly
evaluate an investment adviser’s Form
ADVs when OCIE becomes aware of
issues or problems with an investment
adviser.” Then, “OCIE should document
areas where it believes a Form ADV
contains false information and initiate
appropriate action, such as commencing a
cause examination.”
·
Recalibrate its scoring methodology.
OCIE should “re-evaluate the point scores
that it assigns to advisers” based on both
(i) their reported assets under
management and (ii) the number of
clients to which they provide investment
advisory services. It should “assign
progressively higher risk weightings” to
firms with greater assets or larger
numbers of clients.
·
Add more disclosures to Form ADV.
OIG recommends implementation of a
new rule “that would require the
following additional information to be
reported as part of Form ADV:
o Performance information;
o A fund’s service providers,
custodians, auditors and
Investment Management Update
administrators, and applicable
information about these entities;
the Task Force should lead to more effective
prosecution of financial fraud.
o A hedge fund’s current auditor and
any changes in the auditor; and
The Task Force will focus on “increasing
coordination and fully utilizing the resources
and expertise” of federal, state, local, tribal,
and territorial authorities. “Many financial
frauds are complicated puzzles that require
painstaking efforts to piece together,” SEC
Chairwoman Schapiro said, adding that “by
formally coordinating our efforts, we will
be better able to identify the pieces,
assemble the puzzle, and put an end to the
fraud.”
o The auditor’s opinion of the firm.”
·
·
Finalize proposed Form ADV rule
changes. OIG recommends that the SEC
finalize the proposed amendments to Part
II of Form ADV, first proposed in March
2008. In doing so, OIG stated that the
SEC should consult with OCIE and
“consider [adding] provisions that would
assist OCIE to efficiently and effectively
review and analyze the information in Part
II of Form ADV.”
Develop third-party policies. “OCIE
should develop and adhere to policies and
procedures for conducting third-party
verifications, such that OCIE verifies the
existence of assets, custodian statements,
and other relevant criteria.”
OIG requested that the SEC respond in
January to OIG with a proposed plan to
implement these recommendations.
President Announces New
Interagency Financial Fraud
Enforcement Task Force
President Obama has announced the
establishment of a new Financial Fraud
Enforcement Task Force to combat financial
crime. The Department of Justice will lead
the Task Force and senior officials from the
Department of Treasury, HUD and the SEC
will serve on the steering committee. Other
members of the Task Force will come from a
broad range of federal agencies, regulatory
authorities and inspectors general. The Task
Force also will include representatives from
state and local governments. The creation of
The primary mission of the Task Force is to
provide advice to the Attorney General on the
investigation and prosecution of a litany of
financial crimes, including: bank, mortgage,
loan, and lending fraud; securities and
commodities fraud; retirement plan fraud;
mail and wire fraud; tax crimes; money
laundering; False Claims Act violations;
unfair competition; and discrimination. In
addition to stepping up the government’s
enforcement and prosecution capacity, the
Task Force is intended to help detect and
stop emerging trends in financial fraud
before they’re able to cause extensive,
system-wide damage to the economy.
Robert Khuzami, Director of the SEC’s
Division of Enforcement, who formerly
served as a federal prosecutor with the DOJ,
remarked that the SEC’s “vigorous
enforcement [of financial fraud] is critical
because it offers immediate and public
vindication of certain bedrock principles,”
including “that no one should have an unfair
advantage in our markets and that investors
have a right to truthful and accurate
disclosure; that there be a level playing field
[in the markets]; and that if you stray into
foul territory, there is a high risk that you will
be caught, prosecuted and punished.”
Director Khuzami added that the Task Force
should increase the effectiveness of the
SEC’s recently launched national
specialization units centered on, among
7
other matters, derivatives, insider trading,
and fraud among hedge fund and
investment advisers.
The Financial Fraud Enforcement Task Force
replaces the Corporate Fraud Task Force that
was established in 2002 in the wake of the
bankruptcy of Enron Corporation.
Court Dismisses Excessive
Fee Case But Criticizes
Directors
On December 28, a California federal
district court dismissed an excessive fee
case applying the Gartenberg standard,
but, in an unusual departure from other
excessive fee rulings, also provided
extensive dicta on the role of independent
directors in reviewing advisory and
distribution agreements. In re American
Mutual Funds Fee Litigation. The case was a
victory for the adviser and the industry
generally, insofar as the court applied the
standards set forth in Gartenberg v. Merrill
Lynch Asset Management, Inc. (which was
recently rejected by the 7th Circuit Court of
Appeals in Jones v. Harris Associates L.P.
and modified by the 8th Circuit Court of
Appeals in Gallus v. Ameriprise Financial,
Inc.). The case has garnered attention from
the industry, much of it critical of the
court’s commentary on the role played by
the fund directors.
Background
The suit was brought on behalf of investors in
eight mutual funds and alleged that the funds’
adviser and distributor had “breached the
fiduciary duty imposed on them by Section
36(b) of the Investment Company Act of 1940
with respect to compensation received for
various services rendered to the funds” and
that the funds “were charged excessive
8
February 2010
advisory, Rule 12b-1, and administrative
fees.”
Gartenberg Prevails
Under Section 36(b) of the 1940 Act,
advisers generally have “a fiduciary duty
with respect to the receipt of compensation
for services.” In reaching its decision, the
court considered the legal standard to be
applied to excessive fee claims and noted that
the majority of courts have followed the
standard set forth in Gartenberg. The
court rejected the alternative standards set
forth in Jones (“rejecting Gartenberg
because it relies too little on markets and
holding that, so long as the fiduciary makes
full disclosure the law places no cap on
compensation”) and Gallus (expanding
Section 36(b) “to provide a cause of action
even where the challenged fee passed muster
under the Gartenberg standard”). In rejecting
Jones and Gallus, the court commented that
“the Jones standard ignores the plain
language of Section 36(b) and would
essentially emasculate the statute,” while
Gallus “purports to create a cause of action
based on something other than a breach of
duty in relation to management’s
compensation” and “appears to establish a
duty not contemplated by Section 36(b).”
(Jones is currently pending before the
Supreme Court.)
Application of Gartenberg
The court’s application of the Gartenberg
factors is summarized below.
Nature and Quality of Services. With
respect to the plaintiffs’ claim
regarding 12b-1 fees (that the growth in
assets through the payment of 12b-1 fees
was harmful to the funds, which “were
already experiencing growth that was
causing fund performance to
deteriorate”), the court found that the
claim was not viable under Section
36(b) as it failed to address the nature
Investment Management Update
and quality of the services provided in
exchange for the fees. Moreover, even if
the claim were viable, the court found that
plaintiffs did not adequately demonstrate a
deterioration in fund performance. As for
plaintiffs’ advisory fee claims (which
plaintiffs tried to tie, in part, to allegedly
relatively poor short-term performance
during 2008), the court cited the
“widespread economic turmoil” in 2008
and concluded that the funds’ generally
good to excellent long-term
performance was more indicative of
overall performance. Finally, plaintiffs
alleged that the funds’ administrative fees
were excessive because, after the
imposition of a five basis point cap, the
defendants failed to return amounts that
were over the cap before its imposition.
The court rejected that argument, noting
that plaintiffs “made no effort to compare
[the administrative] services to the fee
exacted, or to challenge the nature and
quality of services provided” and thus
failed to establish that the fees charged
were disproportionate to the services
rendered.
Comparative Fee Structures. The
defendants presented evidence that the
funds’ fees were below industry averages
for comparable funds as measured by
Lipper and Morningstar, and “were often
among the lowest in their respective peer
groups.” While the court stated that “the
evidence of low comparative fees also
supports a finding that Defendants’ fees
were not disproportionate to the services
rendered,” the court did note that
evidence of comparative fee structures,
“though certainly relevant, is of limited
probative value in a Section 36(b)
inquiry because of the potentially
incestuous relationships between many
advisers and their funds.”
Profitability of the Funds. The court
found that profit levels of the funds to
the adviser and its affiliates ranged
from approximately 30% up to 52% on
a stand-alone or combined basis. The
court concluded that these levels fell
“within the range of profit margins that
other courts have deemed acceptable
under Section 36(b)” and were
“comparable to or less than other
similarly structured investment advisers.”
The court also noted, citing Gartenberg,
that the adviser and its affiliates “are
entitled to recoup their costs and to
make a fair profit without having to
fear that they have violated Section
36(b).”
Fall-out Benefits. Fall-out benefits were
defined in Gartenberg as “profits to the
adviser that would not have occurred but
for the existence of the fund.” In this
case, the court found no evidence that the
defendants received fall-out benefits.
Further, the court found that since the
adviser’s revenues were reflected in its
consolidated financials provided to the
funds’ boards, to the extent there were
any fall-out benefits, the benefits would
have been considered by the boards in
connection with their review of the
financial statements.
Economies of Scale. The court found that
plaintiffs’ expert failed to show “that
the adviser’s and its affiliates’ per-unit
operating costs decreased as fund size
increased.” Further, the court noted that
even if economies were assumed to exist,
economies “can be shared with fund
shareholders in a number of ways,
including breakpoints, fee reductions and
waivers, offering low fees from inception,
or making additional investments to
enhance shareholder services.”
The court concluded its application of
Gartenberg by noting that “the Unaffiliated
Directors carefully and diligently exercised
their responsibility in approving the fees at
issue.” Among the factors noted by the
9
court as generally being important in such
an evaluation were the expertise of the
unaffiliated directors, the level of care with
which they performed their duties and the
extent to which they were fully informed.
In this case, the court found that:
·
the funds’ boards were comprised of a
supra-majority of unaffiliated directors;
·
the directors “were well-qualified with
significant experience relevant to the
performance of their duties”;
·
the governance structure of the boards
“allowed the Unaffiliated Directors to
effectively review and analyze the
information provided to them” including
the use of clusters and committees
comprised of unaffiliated directors,
chairpersons who were unaffiliated and
executive sessions;
·
the boards were advised by independent
counsel; and
·
the information provided to the boards
was “comprehensive” and “similar to that
found in past cases to have been more
than sufficient to permit the directors to
make informed and knowledgeable
decisions in approving the fees” such as
information on fund performance and
expense ratios, comparative information
on other funds, financial statements,
information on processing costs and
portfolio transactions, fund agreements
proposed for approval, and a discussion of
the statutory role of directors under
Section 36(b).
Court’s Dicta Criticizes Directors
While the court concluded there was
sufficient evidence to establish the directors
met their obligation under Gartenberg, the
court in dicta, which does not establish
precedent, questioned the adequacy of the
directors’ inquiry into the amount of
compensation paid to adviser and
10
February 2010
distributor employees. Specifically, the
court observed, “there is no evidence that
any director ever asked for such
information, and when management
advised that its compensation levels (which
were undisclosed) were necessary to meet
competition in the marketplace, the
directors simply accepted the claim as
gospel. There is not a shred of evidence that
any director asked management to identify
who [the adviser] perceived as its
competition, to provide information regarding
compensation levels at those competing
firms, to compare those compensation levels
to compensation paid to [fund adviser and
distributor] employees, or to explain why
those compensation levels were necessary.”
The court went on to observe that, “although
the directors were represented by counsel and
were provided with detailed materials to
which they and Defendants can point to and
say, ‘see how thorough and careful we were,’
the entire process seems less a true
negotiation and more an elaborate exercise
in checking off boxes and papering the
file.” As to 12b-1 fees, the court noted, “the
directors apparently failed to consider that the
increase in assets under management resulted
in significant part from appreciation of
existing accounts and not the addition of new
investors. Moreover, no evidence was
presented that the fee was decreased as the
assets under management substantially
decreased.”
Typically, when directors have considered
issues related to compensation of personnel,
they have done so to ensure that the interests
of adviser employees are aligned with those
of the funds and shareholders, and not to
account for the level of that compensation in
determining the reasonableness of advisory
fees. To our knowledge, no other court has
indicated that the compensation paid to
adviser employees is a pertinent factor to
consider in evaluating an advisory contract.
The court did not address or give weight to
Investment Management Update
the fact that payment of 12b-1 fees based on
fund assets (which leads to fee increases when
assets increase and fee decreases when assets
decrease) is an industry-standard arrangement
and could not cite authority for the position
implied in its dicta, nor did the court cite any
authority or provide any argument supporting
its implication that there is a distinction under
Section 36(b) between “true negotiation” and
the careful and conscientious review of the
Gartenberg factors to determine that an
advisory fee is not unreasonable under the
Gartenberg standard.
Note: K&L Gates LLP represents the
independent directors of one of the funds
involved in the above litigation, although
our firm did not provide representation in
connection with the litigation or any
conduct that was the subject of the
litigation.
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